The Legal Loophole That Costs Medicaid Billions

Medicaid is a broadly popular program that provides medical coverage to low-income Americans through a combination of state and federal funding. More than 60 percent of Americans either know someone who has benefited from Medicaid or have been enrolled themselves, according to health policy think tank FFF. So any talk of altering the program usually meets strong opposition.

Yet few seem to know how the system works, what it costs, or the level of unnecessary spending hidden within its $880 billion annual budget.

One example is a little-known quirk in the Medicaid system that allows states to artificially inflate their Medicaid costs to recoup more federal dollars. The arrangement allows some states to pocket a share of the money paid to them for providing treatment to Medicaid patients.

Here’s how it works.

Although, for people who enrolled through the Medicaid expansion under the Affordable Care Act, the reimbursement rate is 90 percent.

So if a state had a 60 percent reimbursement rate and spent $10 billion on Medicaid services, the federal government would reimburse the state $6 billion.

That’s how the system was designed to work back in 1965, generally speaking.

By the mid-1980s, some states had found a way to increase payments to providers and their own Medicaid costs at the expense of the federal government.

First, medical providers would either voluntarily donate money to a state or agree to pay a tax. The states would then return the amount of the donation or tax, and possibly even more, through increased reimbursement. Finally, the states would bill the federal government for the increased cost.

In some cases, the providers initiated these arrangements, according to the Congressional Research Service (CRS).

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For example, a hospital might agree to pay the state $10 million in taxes. The state might then increase Medicaid payments to that hospital by $20 million. If the state’s reimbursement rate was 60 percent, it would receive $12 million in federal Medicaid funding.

Together with the tax income, the state would receive $22 million and pay $20 million, netting $2 million for additional Medicaid costs or other purposes.

The arrangement benefited providers by increasing their reimbursement, and the states benefited by reducing their costs or even gaining revenue. The federal government bore the cost of those increases.

Congress debated the issue in 1991.

Lawmakers who favored keeping the arrangement in some form argued that it had become a vital part of state Medicaid funding.

Rep. Raymond McGrath (R-N.Y.) said at the time that doing away with the system would cost his state $500 million in federal matching funds. He predicted “chaos” in the Medicaid system if provider taxes were abolished.

The administration of President George H.W. Bush strongly opposed the taxes in a position statement, saying, “State donation and provider-specific tax programs, if unchecked, will undermine a basic premise of the Medicaid program—that States have a stake in the costs of the program.”

In the end, Congress chose to impose limits on provider taxes and donations.

First, provider donations to the state are strictly limited to prevent abuse. Second, state taxes must meet certain conditions or the state will lose federal funding.

Taxes must apply to all providers in a certain class, such as nursing homes, not just those who serve Medicaid patients. Also states can’t provide any direct or implied guarantee that they will reimburse providers for the amount of the tax. The limit on provider taxes is 6 percent.

Here’s how the provider tax works today.

And states depend more on tax revenue to fund Medicaid—and other things—according to the Government Accountability Office (GAO).

From 2008 to 2018, the share of states’ Medicaid spending covered by provider taxes grew from 7 percent to 17 percent according to the GAO.

In 2018, states received $63 billion in provider taxes and local government funds, according to GAO estimates. Of that amount, $16 billion (25 percent) was not used to pay providers.

That shifted 5 percent of the cost of Medicaid from the states to the federal government, the GAO estimates. The practice also resulted in lower overall reimbursement to some providers when accounting for their tax payments.

When measured as a percentage of the nation’s gross domestic product (GDP), a common measure of the country’s total wealth, the burden of providing Medicaid remained the same for states from 2008 to 2023. While overall spending went up, the economy was growing, too, so state Medicaid spending was essentially flat according to the think tank Paragon Health Institute.

Yet the overall cost of the program increased dramatically, meaning that the federal government paid the entire increase in the cost of the program over 15 years, according to Paragon.

Over that same period, the federal government’s share of the total cost of Medicaid grew from 60 to 72 percent.

Medicaid accounts for 92 percent of the spending that the committee manages, so changes to the program have been discussed.

Lawmakers have floated ideas such as limiting how much the federal government reimburses the states or reducing the percentage of the reimbursement.

House Speaker Mike Johnson (R-La.) said he won’t do either of those things. “We’re talking about finding efficiencies in every program, not cutting benefits for people who rightly deserve them,” Johnson said in a Feb. 26 interview on CNN.

That has caused some lawmakers to eye the provider taxes.

The Congressional Budget Office (CBO), which provides nonpartisan financial assessments to Congress, estimated the impact of altering the provider tax restrictions.

The CBO discovered that eliminating the tax would reduce the federal deficit by $612 billion over 10 years. Reducing the tax to 2.5 percent would reduce the deficit by $241 billion, and lowering it to 5 percent would bring a $48 billion reduction.

Democrats are firmly united in opposing any Medicaid reductions.

“Republicans are trying to enact the largest cut to Medicaid in American history, and we need to keep the pressure on them legislatively and in communities all across the country,” House Minority Leader Hakeem Jeffries (D-N.Y.) said in a video call with Democratic leaders on March 5.

All 47 Democrat and Independent senators signed a letter to Republican leaders in February, arguing that there’s not enough fraud and waste in the program to offset proposed budget cuts.

Others have defended the device as a way for cash-strapped states to keep Medicaid going. As the CRS notes, the provider tax helps states increase reimbursement to certain types of providers, such as hospitals and nursing homes.

Use of the tax has tended to increase during and after recessions. “Medicaid provider tax revenue can provide a way for states to continue funding the Medicaid program during times of state budget constraints,” according to CRS.

Yet it’s unclear how much limiting state taxes on health care providers would impact Medicaid.

California has more than 12 million Medicaid enrollees and derives more than 60 percent of its Medicaid funding from the federal government. The state reported that its spending on Medicaid from its general fund decreased by 5.8 percent in 2024. Federal Medicaid payments to California increased 1.9 percent that year.

Eliminating all taxes on health care providers would reduce federal Medicaid payments by about 8 percent over 10 years, according to the CBO. Reducing the tax rate would produce reductions of 0.6 to 3 percent.

“I just don’t think that’s enough money at stake for states to want to cut their [Medicaid] expansion population,” Niklas Kleinworth of Paragon Health Institute told The Epoch Times.

Kleinworth theorized that states would be more likely to cut funding for what are called social determinants of health such as home modifications, non-medical transportation, and education.

“You'll probably see states making their Medicaid programs more efficient,” Kleinworth said.

The true impact is difficult to predict because the total amount of provider tax revenues states use on Medicaid expenditures is not fully known, according to CRS.

Noting that fact, the GAO recommended five years ago that the Centers for Medicare and Medicaid Services collect complete and consistent information on all sources of funding used by states to finance Medicaid, including provider taxes.

As of February, the recommendation has not been implemented.